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Swaps provide “unfunded” financial exposure to assets: you don’t own the assets, much less pay for them: you don’t have to put any money down up front at all.<ref>Besides any [[initial margin]] your counterparty required: see below.</ref> This is, economically, the same as betting.<ref>It is also the same as buying (or selling) insurance, with one difference: to be insured, you must suffer an insurable loss.</ref> Given the size of individual swap transactions — typically in the millions of dollars — your total notional exposure can quickly blow out of all proportion. The market hit upon two neat tricks to manage these risks: [[netting]] and [[credit support]]. | Swaps provide “unfunded” financial exposure to assets: you don’t own the assets, much less pay for them: you don’t have to put any money down up front at all.<ref>Besides any [[initial margin]] your counterparty required: see below.</ref> This is, economically, the same as betting.<ref>It is also the same as buying (or selling) insurance, with one difference: to be insured, you must suffer an insurable loss.</ref> Given the size of individual swap transactions — typically in the millions of dollars — your total notional exposure can quickly blow out of all proportion. The market hit upon two neat tricks to manage these risks: [[netting]] and [[credit support]]. | ||
==== Netting ==== | |||
We are not really concerned with netting here — the [[JC]] has plenty to say on that topic [[Close-out netting|elsewhere]] — so let’s quickly deal with it: just as you could offset the [[present value]] of the opposing legs of each swap to calculate a positive or negative [[mark-to-market]] value for that swap, so too could you offset positive and negative [[mark-to-market]] values for different swaps to arrive at a single net exposure for your whole {{isdama}}. This idea — [[close-out netting]] — was a stroke of genius, and the brave commandos of {{icds}} encoded this “[[single agreement]]” concept into the {{1987ma}} and its successors. | We are not really concerned with netting here — the [[JC]] has plenty to say on that topic [[Close-out netting|elsewhere]] — so let’s quickly deal with it: just as you could offset the [[present value]] of the opposing legs of each swap to calculate a positive or negative [[mark-to-market]] value for that swap, so too could you offset positive and negative [[mark-to-market]] values for different swaps to arrive at a single net exposure for your whole {{isdama}}. This idea — [[close-out netting]] — was a stroke of genius, and the brave commandos of {{icds}} encoded this “[[single agreement]]” concept into the {{1987ma}} and its successors. | ||
But even with netting, | ==== Credit support ==== | ||
But even with netting, the highly [[Leverage|levered]] nature of swap transactions meant that one’s overall net exposure could swing around wildly. | |||
A solution arrived a decade or so after swap trading started in earnest. In 1994 ISDA released a “[[credit support annex]]” to the {{isdama}} under which | A solution arrived a decade or so after swap trading started in earnest. In 1994 ISDA released a “[[credit support annex]]” to the {{isdama}} under which the parties could exchange “credit support” to each other to offset their prevailing exposures to each other. This is all rather complicated and fiddly<ref>See our [[CSA Anatomy]], for as much detail as any one person could want.</ref> but the gist of it was that you could calculate your net [[exposure]] to your counterparty on any day and, if it was over an agreed threshold, you could require your counterparty “post” cash, bonds or liquid securities to you as collateral for that exposure. If the exposure swung back, the counterparty could require you to return those assets tomorrow. Rinse and repeat. | ||
Like the {{Isdama}}, the [[CSA]] is a bilateral document: it assumes the parties are equal, arm’s-length counterparties and that each can post to the other. In the early days, [[Swap dealer|swap dealers]] often adjusted their CSAs so that only the customer posted credit support. Over this period, the [[Basel Accords]] published increasingly stringent and detailed rules<ref>Basel I was 30 pages. Basel II, published June 2006 (whoops!) was 347 pages. Basel III, as of September 2021, is 1626 pages.</ref> about how much capital banks should hold against their trading exposures to their customers. If at first customers were less bothered about the creditworthiness of their swap dealers,<ref>To be sure, sophisticated investment managers were already requiring their dealers post [[variation margin]] by the the start of the new millennium.</ref> this all changed, fast, during the 2008 financial crisis in which every major dealer had at least a near-death experience, if not an actual one. | |||
Suddenly the dealers, themselves, were a source of systemic risk. The regulatory reform machine moved into overdrive; the era of unregulated derivatives was over. Regulators the world over began requiring all swap counterparties to collect [[variation margin]] on all common forms of swap contract: bilateral, daily, and in [[Cash|''cash'']]. | |||
===== Remember the good old days ===== | |||
Now remember that old distinction between intermediary and customer. Intermediaries are meant to be well-capitalised; they don’t have a dog in the fight: their interest is just in collecting their commission. Their customers take the market risks. | |||
Swap dealers ''look'' like they are taking market risks, but they are not. Post Volcker, they are not ''allowed'' to. Swap dealers are passing on the return of their hedging activity to their customers, and collecting commissions and interest on financing.<ref>We have in mind [[Synthetic equity swap|synthetic equity derivatives]] here. This may be less clearly the case in other asset classes, but it is still (post Volcker) broadly true for all of them.</ref> | |||
You can, and physical [[prime brokerage]] customers do, achieve exactly the same effect with a margin loan: the customer buys shares on margin; the [[prime broker]] holds the shares as collateral for the loan. If the shares decline in value, the broker may call for more margin. If the shares rise in value, the customer generates increased equity with the broker, but is not automatically entitled to the cash value of that equity. There is no variation margin, as such. | |||
The | The prime broker may ''agree'' to lend more against that equity — that is the business it is in, after all — but it is not ''obliged'' to. The customer cannot force the broker to lend against the equity. As long as it leaves enough equity in the account the customer may withdraw excess equity, but only by taking the shares it owns. Withdrawing ''shares'' from a prime brokerage account doesn’t fundamentally change ones debtor/creditor relationship. Withdrawing cash ''against'' shares assuredly does. | ||
The nature of a synthetic swap position is different in that regard: any positive equity is an unsecured claim against the prime broker. However, traditionally, this credit risk would have been managed by reliance on prudential regulation rather than funded credit mitigation. | The nature of a synthetic swap position is different in that regard: any positive equity is an unsecured claim against the prime broker. However, traditionally, this credit risk would have been managed by reliance on prudential regulation rather than funded credit mitigation. |